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(Source – Pexels/Aleksandar Pasaric)
As I’ve mentioned in recent articles, REITs appear to be one of the best defensive equity plays on the market today. As interest rates seem to be ever on the decline, real estate cap-rates fall and property values rise. After seeing a real estate crash from 2006 to 2009, many U.S investors have been fearful when it comes to investing in the property market. As the global economy continues to weaken, they have been underestimating the risks in other “defensive” sectors like utilities and consumer staples and overestimating risks in real estate.
Frankly, U.S REITs don’t offer that great of dividends with the popular ETF (VNQ) yielding only about 3%. Better than other historically defensive sectors, but not as great as what is found overseas.
If you’re looking for a better value opportunity, the Vanguard International Real Estate ETF (VNQI) may be for you. The fund invests in REITs around the world with roughly a quarter in Europe, Japan, Emerging Markets, and mainland Asia respectively. In my opinion, the international property markets look like a better risk-reward than the U.S., everywhere besides Hong Kong and China (which make up 22% of the fund).
Let’s take a deep dive into the fund to see if it is had any hidden risk and to asses its long-term opportunities.
The Vanguard Ex-US Real Estate ETF
The ETF currently pays an estimated dividend yield of 4% and has an extremely low expense ratio of 12 basis points as is typical among Vanguard funds. The fund trades at a weighted average “P/E” ratio of merely 10.5X and has high earnings growth, return on equity, and trade around its NAV.
The fund has been trading since the beginning of 2011 and has resulted in a roughly 60% total return since then. This is admittedly lower than its U.S. peer VNQ, but also indicates that VNQI is more likely to outperform VNQ going forward as it trades at a much lower valuation.
The fund is extremely liquid with $6.4 billion in AUM, so it is liquid enough for all investors. Let’s take a closer look at that AUM figure to see if there is growing or declining investor interest in the ETF:
Data by YCharts
As you can see, the fund has seen strong and stable inflows since its inception and saw very high inflows in 2017 as it saw strong performance that year. If interest continues to climb at this pace, it may help the ETF finally break above the $60 level.
A major factor I like about REITs and particularly about international REITs is their diversification value. While the fund will certainly fall due to a global recession, it has a natural floor due to the value of the underlying property assets. Even more, it is a hedge against inflation, particularly runaway inflation that is above interest rates that is created by QE and negative rates.
As an extreme example, the Danish Jyske Bank (OTC:JYSKF) offers mortgages with negative interest rates, which means that those taking out a mortgage get paid for the privilege of doing so. You’d be silly to not take out a mortgage and buy property in such an environment.
Despite the fact that money is essentially free in Europe and Japan, those economy’s rental properties still offer a 4-6% yield. This results in huge profit margins for REITs in those countries. If this zero to negative rate bonanza continues, property prices in Europe and Japan could go much higher.
Let’s take a closer look at the fundamentals of those REITs to see if they’re taking advantage of this unique opportunity.
VNQI Cheap with Positive Growth
Overall, VNQI is a much better deal than VNQ. Take a look at the equity characteristics of VNQ (left) vs. that of VNQI (right):
(Source – Vanguard)
From a price-to-earnings and a price-to-book standpoint, VNQI is trading at a 50% to 65% discount to VNQ. Of course, there are slightly higher risks in VNQI, but not enough to explain that huge gap. Earnings growth has been higher in VNQ, but the return on equity is much higher in VNQI. Even more, VNQI holds smaller companies and is much more diversified as it has over 600 holdings.
Usually, this is a sign that investors are concerned about the balance sheet situation of the REITs. Here is a fundamental breakdown of a random sample of 50 companies in the fund:
Note, “typical” indicates the harmonic mean for valuation ratios and median for others. Also, because many of these companies are overseas, so the data may be off so please cross-reference it yourself before making investment decisions.
(Data Source – Unclestock)
Valuations are a bit higher when you look at the fund from an “equal weighted” perspective like this as seen in the higher typical “P/E” ratio. We can also see that the typical company is trading at a 10% historical discount from a five-year average price-to-sales perspective.
Most of these REITs also trade near book value. This is less common in U.S. REITs as book value tends to be below market value, therefore the fund may be trading below net asset value of the underlying properties.
The major plus of the fund is its very low debt ratios. This came as a major surprise to me considering the extremely low global interest rates. REITs in the U.S. typically have much higher leverage ratios of 70% or higher.
One area of concern I have is the cash balances of many of these companies. Current ratios are pretty low for many of these REITs. Having poor cash balances is not as big of a deal for REITs as income is pretty stable, but can become a concern if interest rates spike higher.
Revenue growth is pretty strong with the median company seeing 5% in growth last year and 5% on average over the past three years. 20% of the fund is invested in emerging markets that are likely to see rents rise dramatically over the next decade.
Overall, these companies beat those in VNQ by a wide margin and are likely to outperform over the long run.
The Bottom Line
Most investors today are concerned about deteriorating global macroeconomic fundamentals. I agree that global residential property is on the expensive side (specifically single-family type housing in the Australasian region), but the REITs in VNQI are less exposed to that risk.
Global mortgage rates are at extreme lows and cap rates are much higher. If you prefer to buy the individual REITs instead of the entire basket, you will probably find the best opportunities in Europe and Japan where the difference between cap rates and mortgage rates is extreme. This results in great cash flows and more price appreciation potential for the underlying properties.
One important risk factor when considering the fund is its negative U.S. dollar exposure. It invests in foreign companies, so if the U.S dollar continues to strengthen against other currencies, VNQI will struggle. I am bullish on the U.S. dollar (UUP), so I may wait two or three months for the dollar rally to cool before I make an investment.
Of course, if mortgage spreads rise and/or if the global economy continues to cool, VNQI will most definitely see a downside. The fund is heavily diversified, but still has a beta of roughly 0.7-0.8 to the S&P 500. In my opinion, VNQI is best suited for a long-term investor who is willing to weather some volatility. Still, I expect VNQI to outperform both the S&P 500 and its U.S. peer VNQ over the next years.
Right now, I’ll be waiting for a buying opportunity. The fundamentals for VNQI are great, but I imagine the fund may retest the $50-55 zones in the coming months.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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